Everybody talks about it — “it’s like herding cats” — but here are the men who do it.
You won’t want to miss that. But once you’ve seen the cat herders in action, you may want to turn your attention to the unsettled nature of the markets. For that, I’ve gotten permission from Aristides’ Chris Brown to share with you his monthly letter, emailed yesterday from Toledo. Chris is scary smart, so I pay attention.
1 September 2015
Aristides Fund LP celebrated its seventh anniversary by posting its best August since 2009, gaining 1.47%. . . . One hundred thousand dollars invested at the inception of Aristides Fund LP, August 15, 2008, is now worth $344,150, representing growth of 19.1% annualized. . . .
Several of you have asked for our thoughts on the recent market sell-off, so, although we have no special powers of market timing and no economic crystal ball, here goes. In the very short term, market sentiment was excessively fearful last week, meaning that it is unlikely that the market goes meaningfully (more than 2-3% below) the lows from August 24 over the next 3-5 weeks. Historically, it would also be more likely than not that we do have some sort of retest of those lows in the very near term.
Longer-term, we remain very guarded in our outlook for equities. Mebane Faber recently (May 31) published a great article called “10 Bearish Charts, 1 Bullish Chart” in which he points out that April 2015 had the highest level of U.S. corporate stock buybacks ever, that May 2015 had the highest ever value of mergers and acquisitions, that the average price of these M&A deals was 12.4x EV/EBITDA year-to-date (highest on record), that the percent of initial public offerings that are unprofitable companies is the highest ever, that the Shiller cyclically-adjusted price/earnings ratio is the 4th highest it has ever been (next to 2000, 1929, and 2007), that the price-to-sales, price-to-book, and price-to-cash flow ratio of the median S&P 500 stock are at all-time highs, that % of portfolio allocation to equities has only been higher in the late 1990s and the late 1960s, that margin debt is at all-time highs, and that average Investor’s Intelligence bullish sentiment in 2014 was the second-highest on record.
Equity bulls counter that the “equity risk premium,” the gap between the earnings yield on stocks and the yield on bonds, is very large currently (i.e. stocks are cheap relative to bonds), and likewise that there are factors that have permanently raised after-tax corporate profit margins (e.g. better corporate management, more oligopolies, less power of labor to demand higher wages, and creative tax management strategies).
If we’ve learned one thing from the great economic prosperity/bull market from 1982-2000, and the subsequent unwind, it is that economies look a lot better when the level of debt-to-GDP is on the rise, and that it’s a pretty hard slog when debt-to-GDP is contracting (or, for that matter, it has been quite a headwind, compared to what we had grown accustomed to, just to have debt-to-GDP stay the same). This is probably the most important and most underappreciated aspect of long-term economic cycles.
Debt-to-GDP in the United States has declined very modestly since 2008, from a very high peak, but is still much closer to a top than a bottom. Therefore, it’s probably safe to argue that downside risks to the economy outweigh the prospects for a new economic boom. Combine this with high valuations, and stocks are vulnerable.
Another immensely important yet underappreciated principal of the markets is that things don’t matter until they do. Just as the massive credit buildup in the U.S. was obvious to some smart folks for years, it didn’t matter to markets in 1994; it didn’t matter until it started to reverse itself, very quickly, in 2007.
The world’s second largest economy, China, has been on the biggest fixed capital investment binge in the history of earth for about the last fifteen years (or roughly double the length of time of the second-longest such binge). You might think of China as a very export-driven economy, but that is only part of the story. Net exports (exports less imports) account for only about 4 percent of Chinese GDP. The amount of China’s economy dependent upon fixed capital investment is astronomical. For example, from 2011 to 2013, in three years, China produced more concrete than the United States did in the entire 20th century.
Certainly the Chinese people are well-educated, hardworking, and industrious, but the Chinese “economic miracle” had another tailwind as well. Any guesses what it might be?
Surprise! It’s debt. While China’s economy has grown, China’s debt, especially corporate debt and local government debt, has grown much more dramatically.
People who say “The fall of the Chinese stock market is inconsequential to the wealth of most Chinese people” are correct in the same way that people who said “Subprime loans are a very small part of the loan market and an inconsequential part of U.S. GDP” were correct in 2006-2007. The dramatic rise and fall of the Shanghai index in the last 12 months is a symptom of debt becoming too widely available, and abused for speculative purposes (margin lending on stocks, in this particular instance), followed by the beginning of a contraction of debt.
Although even margin debt is a relatively small part of China’s economy, the willingness of Chinese individuals to extend credit to Chinese corporations is a key part of the Chinese economy. Chinese GDP has been growing more slowly than Chinese debt for several years now, and if credit conditions tighten in China, the world’s second largest economy is likely to slow considerably.
Already, key commodity inputs that had previously been buoyed by Chinese demand, including iron ore, copper, and oil, have fallen dramatically. The same is true for the currencies of countries whose economies heavily depend on exporting commodities, such as Brazil, Australia, Russia, and Canada.
Many countries are heavily dependent upon exports to China. Nearly 30% of Australia’s exports are delivered to China. Chile, Peru, and Brazil together send roughly 20% of their exports to China, so any slowdown in China could hurt an already fragile South American economy. Likewise, South Korea and Japan send China 24% and 18% of their exports, respectively. Even 10% of European Union exports (roughly 1.1% of the entire EU economy) go directly to China.
China has already devalued the yuan slightly, and has spent a small fraction of its considerable foreign currency reserves defending the currency and its stock market. If the yuan needs to depreciate much further, as some observers are speculating, the effects on China’s economic Asian competitors, such as Japan, could be profound.
To make a long story short, China has accounted for a very substantial portion of global GDP growth in the post-2008 period, so in a world that is heavily indebted and barely growing, a significant economic slowdown and currency devaluation in China would be bad news for many industries in many nations.
We aren’t scrambling to put on China-related shorts. Some other investors, like Jim Chanos, who are better at discerning macroeconomic trends than we are, have already had such positions on for more than a year, and have made a lot of money in the process. We don’t know how far along things are, or how bad they will actually get, and we know that by the time that even guys sitting in Toledo, Ohio, have access to the narrative, maybe the bottom is in or at the very least it’s probably about time for a counter-trend rally. But, nevertheless, it’s important to respect the fact that not all is rosy in the global economy.
Most of our thoughts these days, as usual, are on finding good opportunities one company at a time, both on the long side, and to a lesser extent on the short side. Our broad market hedges obviously did well in August, but we also made considerable money elsewhere. Unwired Planet performed well for us thus far, and the story is still very underappreciated, in spite of us writing about it on SeekingAlpha. MAST Capital privately bought a large chunk of UPIP stock for $1.00 last month. Yet the stock is still below 80 cents in the open market!
Southern Missouri Bancorp finally got the rally it should have had three months earlier (when it said on a conference call that they would pay their SBLF funds back without a capital raise, unless an attractive acquisition came along).
EMCORE, which is still mostly a pile of cash, rallied off of strong earnings.
Our SAExploration bonds traded up even as oil (which we are short as a hedge) traded down; the price isn’t a fluke as (1) we sold $1 million face (we could have sold more but didn’t want to), and (2) Fidelity exchanged $10 million face worth of bonds for stock essentially priced at about $4.25 per share, well above the current market price. The bonds still yield about 25% to maturity.
Our small shorts in Mobileye (a great company that is massively, massively overpriced) and 6D Global Technologies (a bad company that is massively, massively overpriced) contributed meaningfully.
Kroger did not perform well, but was noteworthy in that we were able to buy 20,000 shares on the day of the market panic at an incredible price, and sell it 5 points higher about an hour later.
Of course, several positions lost money, as you’d expect with the market down six percent, but nothing got hit too badly, and all-in-all, we held up pretty well.
Thank you for your partnership. It’s anyone’s guess what the rest of the year will bring to the markets, but we will certainly try our best to continue to keep our assets buffered and to find some good opportunities along the way.
None of this is to say what will happen next — or that you should do anything about this (I bought a few shares of UPIP at 77 cents). If you’re in the stock market with money you won’t need to touch for many years, which is the only sensible way to be in the market, the last thing you want to do is jump in and out. But won’t you feel more knowledgeable around the barbecue this weekend? “Do you know, guys: China produced more concrete in three years than we did in the entire 20th Century? Pass me the relish?”
Quote of the Day
A penny saved may be a penny earned, but it's one boring penny. A penny invested, on the other hand, bounces around. It gets bigger one day, smaller the next. A bit player in the drama of global finance, that penny buys a guy a balcony seat in the theater of macroeconomics.~Susan Stewart
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